Will new bailout for homeowners help?

This post comes from Marilyn Lewis of MSN Money.

There's new talk of partial debt forgiveness for homeowners who have government-backed mortgages. Discussions revolve around whether writing down mortgage balances is a good idea, morally, and whether it could do any good to heal the housing market.

A quick recap: Federal Housing Finance Agency chief Ed DeMarco is the guy who'll make the decision. He has opposed principal write-downs. Until now. He's possibly reconsidering because the Treasury Department has offered to bear the costs.

DeMarco has said he'll decide this month. He oversees Fannie Mae and Freddie Mac, which together guarantee and control about half of the country's 11 million underwater mortgages.

Only 300,000 or so mortgages would be eligible for a balance write-down. The mortgage principal would have to be at least 25% greater than the valiue of the home. Borrowers would also have to be late on their mortgage payments.

While DeMarco chews over the idea, we can, too. Here are some of the pros and cons. Have we missed any? Let us know. Are mortgage write-downs a good idea for underwater homeowners?

Pros

Write-downs aren't untested. In the third quarter of 2011, about 15% of private loan modifications included principal reduction, says Huffington Post columnist David Abromowitz, senior fellow at the Center for American Progress.

Lender Ocwen Financial has a program it calls "Shared Appreciation Modification," for example. Delinquent borrowers' principal is reduced to 95% of the home's current value. In exchange, homeowners agree to share 25% of any appreciation in the home's value with mortgage investors.

In January, almost half of the modifications of nongovernment-backed​ loans under the Making Home Affordable program had principal reductions. Among the 44,058 modifications, balances were reduced by a median amount of $68,063 (half were reduced by more, half by less). 

But principal reductions on government-backed mortgages have not been tried. Fans of the idea include the chiefs of Fannie and Freddie.

NPR writes: "In recent days, financial executives at Fannie and Freddie have made presentations to their regulator saying that principal reduction for many homeowners would prevent larger losses and keep people in their homes."

ProPublica, the nonprofit news agency, adds: "That, in turn, would help taxpayers, who bailed out the companies (Fannie and Freddie) at a cost of more than $150 billion and are still on the hook for future losses." (Post continues below.)

Another vocal supporter is Mark Zandi, the chief economist at Moody's Analytics. He believes principal reductions give underwater homeowners an incentive to keep paying back their loans. Reports NPR:

As Zandi explains, if someone is struggling to pay a $200,000 mortgage and their house is only worth $150,000, the owner might decide to walk away. But if the lender forgives $50,000 of the amount owed, that's a game changer.

Abromowitz, at HuffPo, says:

Recent research from Amherst Securities found that severely underwater loans -- where much more is owed than a house is worth -- default at a much higher rate than loans at or below the home value. This is true across all mortgage types (prime, subprime, Alt-A, etc.), even after accounting for borrower characteristics like credit scores and debt-to-income ratios, according to the report.

Cons

DeMarco has estimated the cost of principal write-downs at $100 billion for Freddie and Fannie.

Treasury would use money from a pool of unspent Troubled Asset Relief Program funds. There'd be no new taxes or congressional allocations. Still, some people oppose any more taxpayer bailouts for housing.

Most criticism, however, centers on problems that could arise from rewarding people for defaulting. NPR quotes Anthony Sanders, a professor of finance in the School of Management at George Mason University:

"Once you throw in principal reductions as a carrot, the level of disinformation from consumers will be legion," Sanders says. "People will then pretend they have to go into default just to get the principal reduction."

The Journal adds:

One study suggests such concerns aren't without reason. In 2008, Bank of America agreed to modify mortgages in a settlement related to allegedly predatory lending practices at Countrywide Financial Corp. A study published in January 2011 by economists at Columbia University concluded that Countrywide's relative delinquency rate "increased substantially . . . during the months immediately after the public announcement of settlement."

Other experts say that need not be a problem: Fannie and Freddie could design their plans to avoid encouraging defaults. For example, they could limit eligibility to only those in default before the program began.

Reader comments to a Wall Street Journal blog post -- "Is mortgage-debt forgiveness worth the 'moral hazard'?" -- make you wonder if a damaging climate of cynicism could be created among those who keep up with their bills and don't get rewards.

Journal readers are debating the problem here. One reader, "Paleo," writes:

Bailing out banks was wrong, and bailing out individuals is also wrong. The first wrong cannot be "righted" by conducting another wrong.

Another reader, "f," writes:

The sooner the market is allowed to get on with that process the better. No more HAMP, HARP, HASP, TARP, etc.

Puts in "Chaotician":

Bankers talking about Morailty is an oxymoron! . . . (U)ntil and if the mortgage losses are absorbed by the system, not the hom eowner victims; we will continue to limp along for a decade of stagnation or worse! The forced inable to relocate for work is itself a crushing baricade to economic recovery!

Here's a final criticism of balance-reduction programs: They don't reduce the size of a homeowner's mortgage payment. The payment amount, some say, is the deciding factor in whether a borrower sticks with a loan.

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"We have found that payment reduction, not loan-to-value, is the key indicator of success in loan modification," DeMarco said in a speech to the Boston Security Analysts Society.

"The bottom line is, if you can get the payment down to a reasonable level, people do not generally default on their mortgages," Paul Willen, a senior economist with the Federal Reserve Bank of Boston, says in the WSJ..

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